Have entrustment loans in China become obsolete?

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Entrustment Loans versus Inter-company Lending

Prior to the Supreme People’s Court of the PRC’s (SPC) promulgation of the Provisions of the Supreme People’s Court on Several Issues concerning the Application of Law in the Trial of Private Lending Cases in August 2015 (effective as of September 1, 2015) (the '2015 Provisions'), the validity of private lending contracts signed between non-financial entities has always been questionable.

Traditionally, the SPC has adhered strictly to its interpretation in the SPC Reply on How to Deal with Failure in Repaying Loans by Borrowers of Loan Contracts between Enterprises (issued on September 23, 1996) (the '1996 Interpretation'), which stipulates that 'loan contracts between (non-financial) enterprises that are in violation with relevant financial laws and regulations shall be invalid'. Although the 1996 Interpretation does not explicitly state what financial laws and regulations are to govern the validity of lending between companies, Articles 61 and 73 of the General Rules on Loans (promulgated by the People’s Bank of China on June 28, 1996), which prohibited direct lending between non-banking entities, had been applied and referred to as the legal basis for prohibiting inter-company lending. As a result of the previous restrictions on private lending/borrowing, the use of banks’ off-balance sheet vehicles, such as entrustment loans, has emerged as an alternative source of lending in China.

An entrustment loan involves a bank acting as an agent of entrusted funds from a depositor company, and then lending the entrusted funds to a borrower designated by the depositor company. The entrusted bank is responsible for the collection of principal and any interest, for which it charges a handling fee, but does not undertake any of the loan risk, which remains with the depositor company.

The prohibition against private lending has now been lifted under Article 11 of the 2015 Provisions. It is clear that, subject to limited exceptions, an inter-company loan agreement for the purpose of production or business operations shall in principle be held valid by the courts. With the recognition of validity of inter-company loan agreements, it becomes a question of whether entrustment loans have become obsolete.

According to the Reports on the Statistical Data of Social Financing Scale issued by the People’s Bank of China in 2016, the balance of entrustment loans was RMB13.2 trillion with an increase of 19.8% and in the first half of 2017, the balance of entrustment loans was RMB598.8 billion, which was RMB447.7 billion lesser than that of the same period in 2016. From such figures, it is difficult to decipher whether there has been a significant decline in entrustment loan in terms of amount of money since the enforcement of the 2015 Provisions.

Furthermore, the validity of an inter-company loan agreement can still be challenged if the following circumstances, as set out under Article 52 of the PRC Contract Law and Article 14 of the 2015 Provisions, are triggered:

Under Article 14 of the 2015 Provisions, an inter-company loan agreement is deemed invalid if:

(1) an enterprise’s credit funds are fraudulently obtained from financial institutions and are then lent to a borrower with high interest;

(2) an enterprise’s loans are obtained from other companies or are raised from employees of a company, which are then lent to a borrower to make profit;

(3) the lender knows in advance that the loan will be used for illegal activities, but still provides the loan;

(4) the contract violates public order or good customs; or

(5) the loan is in violation of mandatory provisions of laws and administrative regulations.
Under Article 52 of the PRC Contract Law, a contract is deemed invalid if:

(a) the use of fraud or coercion by one party damages the interests of the State;

(b) malicious collusion is conducted to damage the interests of the State, a collective or a third party;

(e) it violates any mandatory provisions of law and administrative regulations.

Based on items (5) and (e) above, the SPC would no longer determine the validity of private loan contracts based on the relevant financial laws and regulations, but instead, the mandatory provisions of laws and administrative regulations. Consequently, the Chinese courts will not consider the General Rules on Loans when determining the validity of private loan contracts, as the General Rules on Loans are departmental rules, which are lower than administrative regulations in the PRC law hierarchy. As such, this poses the issue of whether there are any other 'mandatory provisions of law or administrative regulations', which would prohibit or invalidate inter-company loans in any event.

For example, the Measures for Clampdown of Illegal Financial Institutions and Illegal Financial Business Activities issued by the State Council (revised on January 8, 2011, the 'State Council Measures'), which are administrative regulations, prohibit illegal granting of loans by non-financial institutions without defining what 'illegal granting of loans' means. Therefore, it at least cannot be fully excluded whether inter-company loans could be deemed as 'illegal granting of loans' in violation of the State Council Measures, and thus be caught as a violation of administrative regulations and then an invalidity case under the 2015 Provisions.

Moreover, due to the different functions of the SPC and administrative authorities, such authorities may apply different criteria when deciding on the legality of inter-company lending. This could lead to contradictory results and legal uncertainty. The SPC does not decide whether the activities of the companies involved in the private lending violate the relevant financial regulations and only evaluates the validity of the inter-company loan contract. Even if the inter-company loan contract is valid, there is still the possibility that, at the discretion of the financial administrative authority, the company granting the loan might be deemed violating the administrative regulations by granting the loan without proper license.

Due to these reasons, entrustment loans involving licensed PRC banks are still used when implementing inter-company lending arrangements, despite the legalisation of inter-company loans. Furthermore, compared to inter-company loans, the entrustment loans are better for tax verification and auditing perspectives as banks can provide more compliant and detailed documents and information.

Authors

Daniel Tang

Joyce He

With...insights

Second edition: January 2018

The magazine is intended to highlight a number of the challenges and issues facing our clients both personally and professionally. It covers not only legal issues, but also other topics that matter to you.